Trap 4: Sweat equity no more
One of the greatest opportunities in real estate is the ability to substantially increase value through improving the property, such as making repairs, adding rooms or even constructing entirely new structures. For real estate investors, achieving maximum profitability is all about highest and best use.
When the owner of a property performs this kind of work him or herself rather than paying a third party, it is called sweat equity, and it is an incredibly cost-efficient way for real estate investors to increase their equity at minimal cost.
However, the IRS sees it very differently, viewing an investor's work on the property as a service that is provided to the IRA. Unfortunately, the law expressly prohibits the IRA owner from providing services to the IRA, under threat of tax and penalties that are utterly devastating.
Trap 5: The freedom To "hang" yourself
One would think that using a self-directed IRA would lead to profound freedom for the investor, yet the opposite is true. Although an investor is allowed to invest in nearly any asset class, the rules governing IRAs are very strict, inflexible and wholly unforgiving.
What does it take to break those rules? It is easier than one might think.
Each of the following actions is arguably prohibited for a IRA-owned property:
- Paying any bill connected with an IRA's property with personal rather than IRA funds
- Allowing a boss, colleagues or family to use an IRA's beach-front property
- Allowing one's granddaughter's Girl Scout troop to sell cookies on property owned by the IRA
There is an untold number of ways to unintentionally commit a prohibited transaction, and the IRS has become aggressive recently in identifying these transgressions, as the payoff for them can be huge. It is very plausible that committing any prohibited transaction could result in an IRA value being slashed by 50% to 100%, and there is no simple way to fix these errors.
Despite these risk factors, real estate investors shouldn't automatically avoid self-directed IRAs. There are many excellent reasons for real estate investors to use self-directed IRAs as discussed in this podcast.
Real estate investors should, however, avoid the common assumption that any investment that can be made in an IRA should be made in an IRA. That is dangerously untrue, and the ramifications of making the wrong choice can be very negative for one's financial security during retirement.